This fall marks the third anniversary of the beginning of the financial crisis. Of course, the seeds of the crisis were planted much earlier, and hints about the severity of the subprime mortgage problem began to emerge in 2007.

But the start of the financial crisis is generally recognized as Lehman Brothers’ bankruptcy filing in September of 2008. This was followed by the Emergency Economic Stabilization Act of 2008 and the establishment of the $700 billion Troubled Asset Relief Program, or TARP, a few weeks later.

The marking of this dubious anniversary makes now a good time to go back and, with the benefit of 20/20 hindsight, examine some of the lessons from the financial crisis to help prevent it from happening again.

1. Capitalization and liquidity are critical to survival.
While the genesis of the financial crisis was poor asset quality, the crisis itself was triggered by capital and liquidity shortfalls in the U.S. banking system. Institutions of all sizes, from Bear Stearns to small community banks, ran out of cash before they could solve their asset quality problems and stabilize themselves.

The fact is, the banking industry went into the economic downturn woe-fully undercapitalized considering the level of risk in banks’ balance sheets. Dodd-Frank and BASEL III attempted to address this by establishing higher capital requirements for banks. As equity is raised relative to assets, however, return on equity (ROE) and profitability will be reduced, which will make it harder for community banks to raise capital. Also, new Trust Preferred securities can no longer be counted toward regulatory capital.

The lesson: Adequate capitalization and liquidity are critical to withstanding financial adversity.

2. Beware of too much leverage and borrowed liquidity.
Investment banks used borrowed liquidity to generate phenomenal returns – which was great, until the credit dried up. When they needed cash the most, it was no longer there.

Many builders and developers, small business owners and homeowners also learned this lesson the hard way, borrowing 100 percent (or more) of the value of their property based on the assumption that values always go up. But when this didn’t happen and it was time to refinance or sell, they were stuck.

The lesson: Leverage and borrowed liquidity are great when they’re working for you, but they can be lethal when they turn against you.

3. Risk can be masked, but it never goes away.
The repackaging and securitization of mortgage-backed securities, many of which included toxic subprime loans, is a classic case of “passing the trash”: At every step in the process, someone got paid, took their money off the table, and passed the trash down the line to the next party. But nobody really understood what was in the securities, nor did they understand the risk.

The lesson: You can slice, dice, repackage and sell risk, but that doesn’t mean it disappears.

4. Incentives can have a perverse impact on the perception of risk.
If lenders are incented for loan production but not held accountable for the loan’s outcome, guess what? You’ll get lots of production, and lots of bad loans!

To address this problem, changes recently went into effect that impact how bank mortgage loan originators and mortgage brokers can be compensated. Effective with mortgage loan applications received on or after April 1, 2011, loan originators and mortgage brokers can no longer receive compensation incentives based on the pricing of the loan (e.g., the APR or loan origination charges). Instead, compensation must be based either on a fixed percentage of the loan amount or a flat dollar amount per loan.

The lesson: Compensation incentives must be structured around accountability for loan outcomes and risk management at every level of the bank.

5. Beware of covariance and contagion.
In the run-up to the financial crisis, many banks allowed high concentrations of risky types of loans (such as acquisition and development, commercial real estate, and agriculture) to build up in their portfolios. Often, this was unintentional, as banks didn’t realize the high degree of covariance that existed among borrowers. To avoid high levels of concentration and covariance in your portfolio, try to determine whether:

  • A disproportionate percentage of borrowers are located in the same geographic area
  • This geographic area is dominated by a single industry or large employer
  • A substantial number of borrowers are interrelated; for instance are they directly or indirectly dependent on a single industry?

The lesson: Carefully monitor concentrations and covariance in your loan portfolio and strive for a diversified mix of borrowers.

6. Portfolio credit risk must be monitored and managed.
In their efforts to monitor credit risk, many banks relied on third-party rating agencies (like Standard and Poor’s and Moody’s) and participating banks instead of doing their own due diligence. Another mistake was relying on prior credit performance as a predictor of future performance. This obviously proved to be costly, especially in situations where banks were aggressive in their underwriting and allowed heavy concentrations of high-risk loans (as noted above).

Instead, banks should monitor and manage risk from both a micro (individual loan) and macro (loan portfolio) perspective. To do this, concentrate on building a model loan portfolio that defines the bank’s limits and acceptable risk concentrations. Based on the model, you can create a structured process for assessing the types of risk in your portfolio, how the risks are changing, and how you should make adjustments to keep your portfolio within your desired risk level.

The lesson: There’s no substitute for solid portfolio information and analysis when it comes to managing credit risk.

7. You must stay on top of the value of your collateral.
In a declining market, banks often hesitate to order collateral appraisals, whether on real estate or chattel, because they know they’ll have to write down and charge off the lower value of the collateral immediately, as directed by ASC 310-40 (FAS 114). This write-off directly impacts the bank’s capital level.

Since the financial crisis began, however, regulators are taking a close look at the accuracy of commercial real estate appraisals, in particular, and how recent they are. They expect banks to re-examine the current market value of CRE held as collateral by reappraising property using assumptions that realistically reflect current market conditions.

The lesson: Make sure you have a policy in place for monitoring the value of collateral and ordering reappraisals, as necessary.

8. Transparency is critical when it comes to contingent liabilities.
Many banks made the mistake of not doing enough due diligence on their borrowers to learn about their true contingent liabilities. For example, a bank might be comfortable with its own debt exposure to a builder/developer and the borrower’s liquidity, but have no idea about this borrower’s debt exposure at other lending institutions, either individually or as guarantors of LLCs.

Banks must focus on their borrowers’ global cash flow and all their liabilities, and determine debt service coverage ratios based on a complete financial and debt picture.

The lesson: You must know and analyze the real and contingent liabilities of your counterparties.

By learning — or in many cases, relearning — these and other lessons now, the banking industry may be able to avoid another crisis a few years down the road. There’s no substitute for solid portfolio information and analysis when it comes to managing credit risk.